When the income tax return for 1919, of the American Code Company, Inc., was being audited in 1925, the company filed with the Commissioner of Internal Revenue a claim for a refund based upon its failure to deduct from its 1919 gross income the amount for which judgment was recovered against it in 1922, on a contested liability for a breach of contract in 1919. The Commissioner of Internal Revenue rejected the claim and asserted a deficiency. His ruling was sustained by the Board of Tax Appeals. American Code Co., Inc., v. Commissioner of Internal Revenue, 10 B. T. A. 476. Its decision was reversed by the United States Circuit Court of Appeals for the Second Circuit. 30 F. (2d) 222, 224. We granted a writ of certiorari. 279 U.S. 832, 49 S.C.t. 481, 73 L. Ed. 982.
The facts on which the claim for the refund is based are as follows: The company agreed to employ Farquhar as sales manager for 18 years from January 3, 1919, the compensation to be a commission based on sales. In May, 1919, it discharged him, for alleged cause. In July, 1919, Farquhar brought suit against it in the Supreme Court of New York for wrongful discharge, claiming $100,000 damages. Affirmative defenses were interposed, and liability was contested. In October, 1919, the company notified the Commissioner of the suit and asked leave to deduct in its income tax return an amount equal to the commissions for 1919 computed on the contract basis. Permission was refused; but the company set up on its books, at the close of the year, a reserve equal to the amount of such commissions, $14,764.79. At the close of 1920, the amount in this reserve was increased by $32,994.09, computed on the same basis. In 1922, after a jury trial, judgment for $21,019.19 was entered in the trial court, and, on appeal by the company, was affirmed by the Appellate Division. The company then prosecuted a further appeal to the Court of Appeals. In 1923 the judgment was affirmed by that court and paid by the company. The judgment having been rendered by the trial court early in 1922 before the books were closed for 1921, the reserve set up was adjusted as of the close of 1921 to the amount of the recovery, $21,019.19. That sum is claimed as the deduction for 1919.
The company kept its books and made its income tax returns on the accrual basis. The Revenue Act of 1918, Act of February 24, 1919, c. 18, § 234(a), (4), 40 Stat. 1057, 1077, 1078, provides that in computing net income 'losses sustained during the taxable year and not compensated for by insurance or otherwise' shall be allowed as deductions. Section 212(b) provides that the net income shall be computed 'in accordance with the method of accounting regularly employed in keeping the books of such taxpayer,' unless the method employed does not clearly reflect the net income. And Article 111 of regulations No. 45 (1920 Ed.) of the Bureau of Internal Revenue provides that a 'person making returns on an accrual basis has the right to deduct all authorized allowances, whether paid in cash or set up as a liability. * * *'
The company's argument, sustained by the Court of Appeals, is that, since the breach of the contract occurred in 1919, all the facts which gave rise to the liability were fixed in that year; that damages must be assessed as of the date of the breach; that the loss therefore occurred in that year; and that it is immaterial that the amount of the damages was not determined or paid until later. Attention is specifically called to the provision in article 111, which declares that, if after making a return 'a taxpayer first ascertains the amount of a loss sustained during a prior taxable year which has not been deducted from gross income, he may render an amended return for such preceding taxable year, including such amount of loss in the deductions from gross income, and may file a claim for refund of the excess tax paid by reason of the failure to deduct such loss in the original return.'